**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-QSB**

 

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| ý                                                                                                                                                                                                                                                                                  | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                    |
| **For the quarterly period ended March 31, 2006**                                                                                                                                                                                                                                       |
|                                                                                                                                                                                                                                                                                    |
| **OR**                                                                                                                                                                                                                                                                                  |
|                                                                                                                                                                                                                                                                                    |
| o                                                                                                                                                                                                                                                                                       | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                                                    |
| **For  the transition period from                   to                       ** |
|                                                                                                                                                                                                                                                                                    |
| **Commission File Number   0-20191**                                                                                                                                                                                                                                               |

 

**INTRUSIONINC.**

(Exactname of small business issuer as specified in its charter)

 
| **Delaware**                                                     | ** ** | **75-1911917**                         |
|------------------------------------------------------------------|------------|----------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) |       | (I.R.S.  Employer  Identification No.) |

 

**1101 East Arapaho Road, Richardson, Texas 75081**

(Addressof principal executive offices)

(ZipCode)

 

**(972) 234-6400**

(Issuer’stelephone number, including area code)

 

**Not Applicable**

Formername, if changed since last report)

 

** * * * * * * * *

 

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days:

Yes ý No o

 

Indicate by check mark whetherthe Registrant is a shell company (as defined in Rule 12b-2 of the ExchangeAct:  Yes o No ý

 

The number of sharesoutstanding of the Registrant’s Common Stock, $0.01 par value, on May 5, 2006was 7,046,213.

 

Transitional Small BusinessDisclosure Format (check one):  Yes o No ý

 

 

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**INTRUSION INC.**

 

INDEX

 
| **PART I – FINANCIAL INFORMATION**                                                                        |       |
|----------------------------------------------------------------------------------------------------------------|------------|
|                                                                                                           |       |
| Item 1. Financial Statements                                                                                   |       |
|                                                                                                           |       |
| Unaudited Condensed  Consolidated Balance Sheets as of March 31, 2006 and December 31, 2005               |       |
|                                                                                                           |       |
| Unaudited Condensed  Consolidated Statements of Operations for the three months ended March 31,  2006 and 2005 | ** ** |
|                                                                                                           |       |
| Unaudited Condensed  Consolidated Statements of Cash Flows for the three months ended March 31,  2006 and 2005 |       |
|                                                                                                           |       |
| Notes to Unaudited Condensed  Consolidated Financial Statements                                                |       |
|                                                                                                           |       |
| Item 2. Management’s  Discussion and Analysis of Financial Condition and Results of Operations            |       |
|                                                                                                           |       |
| Item 3. Controls and Procedures                                                                                |       |
|                                                                                                           |       |
| **PART II – OTHER INFORMATION**                                                                           |       |
|                                                                                                           |       |
| Item 1. Legal Proceedings                                                                                      |       |
|                                                                                                           |       |
| Item 6. Exhibits                                                                                               |       |
|                                                                                                           |       |
| Signature Page                                                                                                 |       |

 

2

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**PART I – FINANCIAL INFORMATION**

 

Item 1. FINANCIAL STATEMENTS

 

**INTRUSION INC. AND SUBSIDIARIES**

UNAUDITEDCONDENSED CONSOLIDATED BALANCE SHEETS

(Inthousands, except par value amounts)

 
| ** **                                                                                                                        | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                        |       |                     |       |                        |       |
| Current Assets:                                                                                                                   |       |                     |       |                        |       |
| Cash and cash equivalents                                                                                                         |       | $                        | 1,119      |                        | $          | 2,844 |   |
| Short-term investments                                                                                                            |       | 500                      |       | 500                         |       |
| Accounts receivable, less allowance for  doubtful accounts of  $89 in 2006 and $102  in 2005                                 |       | 579                      |       | 443                         |       |
| Inventories, net                                                                                                                  |       | 348                      |       | 373                         |       |
| Prepaid expenses                                                                                                                  |       | 185                      |       | 191                         |       |
| Total  current assets                                                                                                             |       | 2,731                    |       | 4,351                       |       |
| Property and equipment, net                                                                                                       |       | 220                      |       | 256                         |       |
| Other assets                                                                                                                      |       | 41                       |       | 41                          |       |
| TOTAL ASSETS                                                                                                                      |       | $                        | 2,992      |                        | $          | 4,648 |   |
|                                                                                                                              |       |                     |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                     |       |                     |       |                        |       |
|                                                                                                                              |       |                     |       |                        |       |
| Current Liabilities:                                                                                                              |       |                     |       |                        |       |
| Accounts payable and accrued expenses                                                                                             |       | $                        | 982        |                        | $          | 1,142 |   |
| Deferred revenue                                                                                                                  |       | 353                      |       | 527                         |       |
| Total current liabilities                                                                                                         |       | 1,335                    |       | 1,669                       |       |
|                                                                                                                              |       |                     |       |                        |       |
| Stockholders’ Equity:                                                                                                        |       |                     |       |                        |       |
| Preferred stock, $0.01 par value:  Authorized Shares – 5,000                                                            |       |                     |       |                        |       |
| Series 1 shares issued and outstanding — 260  in 2006 and 2005  Liquidation preference of $1,332 as of March 31, 2006        |       | 918                      |       | 918                         |       |
| Series 2 shares issued and outstanding — 460  in 2006 and 500 in 2005  Liquidation preference of $1,155 as of March 31, 2006 |       | 724                      |       | 787                         |       |
| Series 3 shares issued and outstanding — 469  in 2006 and 565 in 2005  Liquidation preference of $1,026 as of March 31, 2006 |       | 667                      |       | 805                         |       |
| Common stock, $0.01 par value:                                                                                                    |       |                     |       |                        |       |
| Authorized shares — 80,000                                                                                                   |       |                     |       |                        |       |
| Issued shares — 7,056 in 2006 and 6,919 in  2005

Outstanding shares — 7,046 in 2006 and 6,909  in 2005                 |       | 71                       |       | 69                          |       |
| Common stock held in treasury, at cost – 10  shares                                                                          |       | (362                     | )          | (362                        | )          |
| Additional paid-in capital                                                                                                        |       | 53,346                   |       | 52,994                      |       |
| Accumulated deficit                                                                                                               |       | (53,528                  | )          | (52,053                     | )     |
| Accumulated other comprehensive loss                                                                                              |       | (179                     | )          | (179                        | )     |
| Total stockholders’ equity                                                                                                   |       | 1,657                    |       | 2,979                       |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                   |       | $                        | 2,992      |                        | $          | 4,648 |   |

 

Seeaccompanying notes.

 

3

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**INTRUSIONINC. AND SUBSIDIARIES**UNAUDITED CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share amounts)
| ** **                                                                  | ** ** | **Three  Months Ended** | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                  | ** ** | **March  31,  2006**    | ** ** | **March  31,  2005** | ** ** |
| Net product revenue                                                         |       | $                       | 418        |   | $ | 871 |   |
| Net customer support and maintenance  revenue                               |       | 433                     |       | 314 |   |
| Total revenue                                                               |       | 851                     |       | 1,185 |   |
| Cost of product revenue                                                     |       | 257                     |       | 501 |   |
| Cost of customer support and maintenance  revenue                           |       | 130                     |       | 26 |   |
| Total cost of revenue                                                       |       | 387                     |       | 527 |   |
|                                                                        |       |                    |       |   |   |
| Gross profit                                                                |       | 464                     |       | 658 |   |
|                                                                        |       |                    |       |   |   |
| Operating expenses:                                                         |       |                    |       |   |   |
| Sales and marketing                                                         |       | 817                     |       | 759 |   |
| Research and development                                                    |       | 792                     |       | 702 |   |
| General and administrative                                                  |       | 348                     |       | 228 |   |
|                                                                        |       |                    |       |   |   |
| Operating loss                                                              |       | (1,493                  | )          | (1,031 | ) |
|                                                                        |       |                    |       |   |   |
| Interest income, net                                                        |       | 18                      |       | 4 |   |
|                                                                        |       |                    |       |   |   |
| Loss before income tax provision                                            |       | (1,475                  | )          | (1,027 | ) |
|                                                                        |       |                    |       |   |   |
| Income tax provision                                                        |       | —                  |       | — |   |
|                                                                        |       |                    |       |   |   |
| Net loss                                                                    |       | $                       | (1,475     | ) | $ | (1,027 | ) |
|                                                                        |       |                    |       |   |   |
| Preferred stock dividends accrued                                           |       | (45                     | )          | (29 | )  |
| Beneficial conversion feature on preferred  stock                           |       | —                  |       | (919 | ) |
| Net loss attributable to common  stockholders                               |       | $                       | (1,520     | ) | $ | (1,975 | ) |
|                                                                        |       |                    |       |   |   |
| Net loss per share attributable to common  stockholders (basic and diluted) |       | $                       | (0.22      | ) | $ | (0.33 | ) |
|                                                                        |       |                    |       |   |   |
| Weighted average common shares outstanding,  basic and diluted              |       | 6,981                   |       | 6,030 |   |

 

Seeaccompanying notes.

 

4

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**INTRUSION INC. AND SUBSIDIARIES**UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)

 
| ** **                                                                      | ** ** | **Three  Months Ended** | ** ** |
|---------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                      | ** ** | **March  31,  2006**    | ** ** | **March  31,  2005** | ** ** |
| Operating Activities:                                                           |       |                    |       |   |   |
| Net loss                                                                        |       | $                       | (1,475     | ) | $ | (1,027 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities:    |       |                    |       |   |   |
| Depreciation and amortization                                                   |       | 36                      |       | 39 |   |
| Provision for doubtful accounts                                                 |       | (13                     | )          | (100 | ) |
| Stock based compensation                                                        |       | 198                     |       | — |   |
| Changes in operating assets and  liabilities:                                   |       |                    |       |   |   |
| Accounts receivable                                                             |       | (123                    | )          | 715 |   |
| Inventories                                                                     |       | 25                      |       | 82 |   |
| Prepaid expenses and other assets                                               |       | 6                       |       | 33 |   |
| Accounts payable and accrued expenses                                           |       | (159                    | )          | (310 | ) |
| Deferred revenue                                                                |       | (174                    | )          | (24 | ) |
| Net cash used in operating activities                                           |       | (1,679                  | )          | (592 | ) |
| Investing Activities:                                                           |       |                    |       |   |   |
| Purchases of short-term investments                                             |       | —                  |       | (350 | ) |
| Purchases of property and equipment                                             |       | —                  |       | (56 | ) |
| Net cash used in investing activities                                           |       | —                  |       | (406 | )  |
| Financing Activities:                                                           |       |                    |       |   |   |
| Proceeds from the exercise of employee  stock options                           |       | 1                       |       | — |   |
| Dividends paid on preferred stock                                               |       | (47                     | )          | (35 | ) |
| Proceeds from the issuance of preferred  stock and warrants, net                |       | —                  |       | 2,515 |   |
| Net cash provided by financing activities                                       |       | (46                     | )     | 2,480 |   |
|                                                                            |       |                    |       |   |   |
| Effect of foreign currency translation  adjustment on cash and cash equivalents |       | —                  |       | (6 | ) |
|                                                                            |       |                    |       |   |   |
| Net increase in cash and cash equivalents                                       |       | (1,725                  | )          | 1,476 |   |
| Cash and cash equivalents at beginning of  period                               |       | 2,844                   |       | 2,315 |   |
| Cash and cash equivalents at end of period                                      |       | $                       | 1,119      |   | $ | 3,791 |   |
|                                                                            |       |                    |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF NON CASH  FINANCING ACTIVITIES:                      |       |                    |       |   |   |
|                                                                            |       |                    |       |   |   |
| Fair value of warrants issued in connection  with sale of preferred stock       |       | $                       | —     |   | $ | 815 |   |
| Amortization of preferred stock beneficial  conversion feature                  |       | $                       | —     |   | $ | 919 |   |
| Preferred stock dividends accrued but not  paid                                 |       | $                       | 42         |   | $ | 29 |   |
| Preferred stock financing costs accrued                                         |       | $                       | —     |   | $ | 25 |   |

 

Seeaccompanying notes.

 

5

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**INTRUSION INC. AND SUBSIDIARIES**

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1.     Description of Business

 

Wedevelop, market and support a family of regulated information compliance anddata privacy protection products, entity identification systems along withnetwork intrusion prevention and detection systems that address vital securityissues facing organizations with mission critical business applications orhousing classified, confidential, or customer information assets.  Ourproducts include Compliance CommanderTM for regulated information and dataprivacy protection, TraceCopTM for entity identification and location, SpySnareTMfor real-time inline blocking of spyware and unwanted peer-to-peer applications,and SecureNetTM for network intrusion prevention and detection.

 

We market and distribute ourproducts through a direct sales force to end-users and distributors and bynumerous domestic and international system integrators, managed service providersand value-added resellers. Our end-user customers include high technology,manufacturing, telecommunications, retail, transportation, health care,insurance, entertainment, utilities and energy companies, government entities,financial institutions, and academic institutions.

 

We were organized in Texasin September 1983 and reincorporated in Delaware in October 1995. Formore than 15 years, we provided local area networking equipment and were knownas Optical Data Systems or ODS Networks. On June 1, 2000, we changed ourname from ODS Networks, Inc. to Intrusion.com, Inc., and our Nasdaq tickersymbol from ODSI to INTZ to reflect our focus on intrusion detection solutions.On November 1, 2001, we changed our name from Intrusion.com, Inc. toIntrusion Inc.

 

Our principal executiveoffices are located at 1101 East Arapaho Road, Richardson, Texas 75081, and ourtelephone number is (972) 234-6400. Our website URL is www.intrusion.com. Informationcontained in or linked to our website are not a part of this report. Referencesto “we,” “us” and “our” in this report refer to Intrusion Inc. and itssubsidiaries.

 

As of March 31, 2006, we hadcash, cash equivalents and short-term investments in the amount ofapproximately $1.6 million, down from approximately $3.3 million as ofDecember 31, 2005. The decrease in cash and short-term investments fundedour operations for the first quarter 2006. On March 29, 2006, weestablished a $1.0 million line of credit with Silicon Valley Bank. Ourexisting cash resources, line of credit and projections for increased revenuesfor the remainder of 2006, may not provide sufficient cash resources to financeour operations and expected capital expenditures for the next twelve months. Itis likely that we will need to seek additional debt or equity financing to fundour operations for the next year. Thesufficiency of our cash resources depends to a certain extent on generaleconomic, financial, competitive or other factors beyond our control. Moreover,despite actions to reduce our costs and improve our profitability, ouroperating losses and net operating cash outflows will continue through at leastthe second quarter of 2006. As a result, we may not be able to achieve therevenue and gross margin objectives necessary to achieve positive cash flow orprofitability without obtaining additional equity financing. We do notcurrently have any arrangements for additional financing and we may not be ableto secure additional debt or equity financing on terms acceptable to us, or atall, at the time when we need such funding. Additionally, we may not havesufficient availability under our credit line when additional funds are needed.Furthermore, because our stockholders’ equity of $1.7 million as of March 31,2006 is less than the $2.5 million required by Nasdaq, we must raise additionalcash or increase our sales in order to maintain the listing of our common stockon The Nasdaq Capital market. Although we are currently exploring a range ofalternatives to increase the amount of our cash, we may not be successful, andNasdaq could seek to delist our common stock.

 

2.     Basis of Presentation

 

The accompanying unauditedcondensed consolidated financial statements have been prepared in accordancewith accounting principles generally accepted in the United States for interimfinancial information and with the instructions to Form 10-QSB and Item 310 ofRegulation S-B. Accordingly, they do not include all of the information andfootnotes required by accounting principles generally accepted in the UnitedStates for complete financial statements. The December 31, 2005 balancesheet was derived from audited financial statements, but does not include allthe disclosures required by accounting principles generally accepted in theUnited States. However, we believe that the disclosures are adequate to makethe information presented not misleading. In our opinion, all the adjustments(consisting of normal recurring adjustments) considered necessary for fairpresentation have been included. The results of operations for the three monthperiod ending March 31, 2006 are not necessarily indicative of the results thatmay be achieved for the full fiscal year or for any future period. Theunaudited condensed consolidated financial statements included herein should beread in conjunction with the consolidated financial statements and notesthereto included in the Company’s annual report on Form 10-KSB for the yearended December 31, 2005.

 

6

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3.     Inventories (In thousands)

 
| ** **              | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------|------------|--------------------------|------------|-----------------------------|------------|
|                    |       |                     |       |                        |       |
| Inventories consist of: |       |                     |       |                        |       |
|                    |       |                     |       |                        |       |
| Finished goods          |       | $                        | 240        |                        | $          | 290 |   |
| Work in progress        |       | 9                        |       | 8                           |       |
| Demonstration systems   |       | 99                       |       | 75                          |       |
| Net inventory           |       | $                        | 348        |                        | $          | 373 |   |

 

4.     Accounting for Stock-Based Compensation

 

In December 2004, the Financial Accounting Standards Board issuedStatement of Financial Accounting Standards No. 123 (revised 2004), “Share-BasedPayment” (SFAS 123(R)), which replaces SFAS 123 and supersedes APB Opinion No.25. SFAS 123(R) requires all share-based payments to employees, includinggrants of employee stock options, to be recognized in the financial statementsbased on their fair values. The pro forma disclosures previously permittedunder SFAS 123 no longer will be an alternative to financial statementrecognition.

 

Prior to January 1, 2006, weaccounted for employee stock-based compensation in accordance with APB 25 andfollowed the disclosure requirements in accordance with SFAS 148. Nocompensation cost was recorded for stock options, as all options granted underthe plans have an exercise price equal (at minimum) to the market value of theunderlying common stock on the date of grant.

 

We adopted SFAS 123(R) on January 1, 2006 using the modifiedprospective application method described in the statement. Results forprior periods have not been restated. Stock-based compensation expenserecognized during the period is based on the value of the portion ofstock-based payment awards that is ultimately expected to vest. Stock-basedcompensation expense recognized in the condensed consolidated statement ofoperations during the first quarter of 2006 included compensation expense forstock-based payment awards granted prior to, but not yet vested, as of December31, 2005 based on the grant date fair value estimated in accordance with thepro forma provisions of SFAS 148 and compensation expense for the stock-basedpayment awards granted subsequent to December 31, 2005, based on the grant datefair value estimated in accordance with SFAS 123(R). As stock-basedcompensation expense recognized in the statement of income for the firstquarter of 2006 is based on awards ultimately expected to vest, it has beenreduced for estimated forfeitures. SFAS 123(R) requires forfeitures to beestimated at the time of grant and revised, if necessary, in subsequent periodsif actual forfeitures differ from those estimates. In the pro forma informationrequired under SFAS 148 for the periods prior to 2006, we accounted forforfeitures as they occurred.

 

By adopting SFAS 123(R) we will record substantial non-cash stockcompensation expenses. The adoption of SFAS 123(R) is not expected to have asignificant effect on our financial condition or cash flows but is expected tohave a significant, adverse effect on our results of operations.

 

At March 31, 2006, we had four stock-based compensation plans,which are described below. These plans were developed to retain and attract keyemployees and directors.

 

In 1987, an Incentive Stock Option Plan was established, which providesfor the issuance of options to key employees of the Company to purchase ourcommon stock. The 1987 Incentive Stock Option Plan was terminated onJanuary 26, 1997. The 1987 plan provided for the issuance of up to 300,000shares of common stock upon exercise of options granted pursuant to the plan. Nooptions are outstanding and no options remaining available for issuance underthe 1987 plan.

 

In 1995, we adopted our 1995 Stock Option Plan (the “1995 Plan”), whichprovides for the issuance of up to 400,000 shares of common stock upon exerciseof options granted pursuant to the 1995 Plan. On April 26, 2001, ourstockholders increased the overall number of shares available for issuancepursuant to the plan to 825,000 shares of common stock. The 1995 Plan providesfor the issuance of both non-qualified and incentive stock options to ouremployees, officers, and employee-directors. The 1995 Plan expired by its termson March 21, 2005 and no options were available for future issuance after theexpiration. At March 31, 2006, 67,365 employee options have been exercisedand employee options to purchase a total of 544,095 shares of common stockare outstanding. A total of 2,290,295 options have been granted pursuantto the 1995 Plan, of which, 1,678,835 have been cancelled.

 

7

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In 1995, we adopted the1995 Non-Employee Director Stock Option Plan (the “1995 Non-Employee DirectorPlan”). The 1995 Non-Employee Director Plan provided for the issuance ofnon-qualified stock options to non-employee directors. The 1995 Non-EmployeeDirector Plan was amended in April 2002 to increase the number of sharesavailable for issuance to 65,000 from 40,000 shares. The 1995 Non-EmployeeDirector Plan expired by its terms on March 21, 2005 and no options wereavailable for future issuance after the expiration. No options have beenexercised under the 1995 Non-Employee Director Plan. Non-employee options topurchase a total of 32,500 shares of common stock are outstanding at March31, 2006. A total of 62,500 options have been granted to directorspursuant to the 1995 Non-Employee Director Plan, of which, 30,000 have beencancelled.

 

On March 17, 2005, theBoard approved the 2005 Stock Incentive Plan (the “2005 Plan”), which wasapproved by the stockholders on June 14, 2005. The 2005 Plan serves as areplacement for the 1995 Non-Employee Director Plan and the 1995 Option Planwhich expired by their terms on March 21, 2005. The approval of the 2005Plan had no effect on the 1995 Plans or any options granted pursuant to eitherplan. All options will continue with their existing terms and will be subjectto the 1995 Non-Employee Director Plan or the 1995 Plan, as applicable. Further,the Company will not be able to re-issue any option which is cancelled orterminated under the 1995 Non-Employee Director Plan or the 1995 Option Plan. The2005 Plan provides for the issuance of up to 750,000 shares of common stockupon exercise of options granted pursuant to the 2005 Plan. The 2005 Planconsists of three (3) separate equity incentive programs: the DiscretionaryOption Grant Program; the Stock Issuance Program; and the Automatic OptionGrant Program for non-employee Board members. Officers and employees,non-employee Board members and independent contractors are eligible toparticipate in the Discretionary Option Grant and Stock Issuance Programs. Participationin the Automatic Option Grant Program is limited to non-employee members of theBoard. Each non-employee Board member will receive an option grant for 10,000shares of Common Stock upon initial election or appointment to the Board,provided that individual has not previously been employed by the Company in thepreceding six (6) months. In addition, on the date of each annual stockholdersmeeting, each Board member will automatically be granted an option to purchase5,000 shares of Common Stock, provided he or she has served as a non-employeeBoard member for at least six (6) months. At March 31, 2006, no 2005 planoptions have been exercised and employee and non-employee Board member optionsto purchase a total of 322,000 shares of common stock are outstanding. Atotal of 332,000 options have been granted under the 2005 Plan, of which 10,000have been cancelled and options for 428,000 shares remain available forfuture grant. No shares have been issued pursuant to the Stock IssuanceProgram.

 

The Compensation Committee of our Board of Directors determines for allemployee options, the term of each option, option exercise price within limitsset forth in the plans, number of shares for which each option is granted andthe rate at which each option is exercisable (generally ratably over one, threeor five years from grant date). However, the exercise price of any incentivestock option may not be less than the fair market value of the shares on thedate granted (or less than 110% of the fair market value in the case ofoptionees holding more than 10% of our voting stock of the Company), and theterm cannot exceed ten years (five years for incentive stock options granted toholders of more than 10% of our voting stock).

 

Effect of Adopting SFAS No.123(R)

 

The following is the effectof adopting SFAS No. 123(R) as of January 1, 2006 for the three months endedMarch 31, 2006 (in thousands, except per share data).

 
| ** **                                             | ** ** | **For Three Months  Ended  March 31, 2006** | ** ** |
|--------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
|                                                   |       |                                                            |       |
| Stock-option compensation expense  recognized          |       |                                                            |       |
| (for stock options only):                              |       |                                                            |       |
| Cost of revenue                                        |       | $                                                               | 24         |   |
| Research and development                               |       | 43                                                              |       |
| Sales and marketing                                    |       | 69                                                              |       |
| General and administrative                             |       | 62                                                              |       |
| Effect on net loss                                     |       | $                                                               | 198        |   |
| Effect on basic and diluted earnings per  common share |       | $                                                               | (0.03      | ) |

 

8

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Valuation Assumptions

 

The fair values of option awards were estimated at the date of grantusing a Black-Scholes option-pricing model with the following assumptions:

 
| ** **                             | ** ** | **For Three Months  Ended  March 31, 2006** | ** ** | **For Three Months  Ended  March 31, 2005** | ** ** |
|----------------------------------------|------------|-----------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
|                                   |       |                                                            |       |                                                            |       |
| Weighted average grant date fair value |       | $                                                               | 1.29       |                                                            | $          | 2.37 |   |
| Weighted average assumptions used:     |       |                                                            |       |                                                            |       |
| Expected dividend yield                |       | 0.0                                                             | %          | 0.0                                                             | %          |
| Risk-free interest rate                |       | 4.3                                                             | %          | 4.2                                                             | %          |
| Expected volatility                    |       | 97.4                                                            | %          | 115.0                                                           | %          |
| Expected life (in years)               |       | 5.0                                                             |       | 4.7                                                             |       |
|                                        |            |                                                                 |            |                                                                 |            |  |  |

 

The Black-Scholes option valuation model was developed for use inestimating the fair value of traded options that have no vesting restrictionsand are fully transferable. In addition, option valuation models require theinput of highly subjective assumptions including the expected stock pricevolatility. Because our employee stock options have characteristics significantlydifferent from those of traded options, and because changes in the subjectiveinput assumptions can materially affect the fair value estimate, in management’sopinion, the existing models do not necessarily provide a reliable singlemeasure of the fair value of its employee stock options.

 

Expected volatility is based on historical volatility and in part onimplied volatility. The expected term considers the contractual term of theoption as well as historical exercise and forfeiture behavior. The risk-freeinterest rate is based on the rates in effect on the grant date for U.S.Treasury instruments with maturities matching the relevant expected term of theaward.

 

Stock Incentive Plan Activity

 

Stock option activity under the Company’s various long-term incentiveand director compensation plans during the three months ended March 31, 2006,were as follows:

 
| ** **                       | ** ** | **Number of  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|----------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|
| ** **                       | ** ** | **(in thousands)**     | ** ** | ** **                             | ** ** |
| Outstanding at December 31, 2005 |       | 891                         |       | $                                      | 5.48       |   |
| Granted                          |       | 32                          |       | 1.73                                   |       |
| Exercised                        |       | (1                          | )          | 0.76                                   |       |
| Cancelled                        |       |                        |       |                                   |       |
| Forfeited                        |       | (20                         | )          | 2.78                                   |       |
| Expired                          |       | (3                          | )          | 27.14                                  |       |
|                             |       |                        |       |                                   |       |
| Outstanding at March 31, 2006    |       | 899                         |       | $                                      | 5.34       |   |

 

Summarized information about outstanding stock options as of March 31,2006, that are fully vested and those that are expected to vest in the futureas well as stock options that are fully vested and currently exercisable, areas follows:

 
| ** **                                  | ** ** | **Outstanding Stock  Options (Fully Vested  and Expected to Vest)*** | ** ** | **Options that are  Exercisable** | ** ** |
|---------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| **As of March 31, 2006**                    | ** ** | ** **                                                                                         | ** ** | ** **                                  | ** ** |
| Number of outstanding options               |       | 899                                                                                                |       | 454                                         |       |
| Weighted average remaining contractual life |       | 7.95                                                                                               |       | 6.81                                        |       |
| Weighted average exercise price per share   |       | $                                                                                                  | 5.34       |                                        | $          | 7.77 |   |
| Intrinsic value                             |       | $                                                                                                  | 12         |                                        | $          | 11 |   |

 

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* Includes effects of expected forfeitures

 

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As of March 31, 2006, the total unrecognized compensation cost relatedto non-vested options not yet recognized in the statement of operations totaledapproximately $303 thousand and the weighted period over which these awards areexpected to be recognized was 0.73 years.

 

Pro Forma Presentation forPeriods Prior to the Adoption of SFAS 123(R)

 

Under the modifiedprospective application method, results for prior periods have not beenrestated to reflect the effects of implementing SFAS No. 123(R). The followingpro forma information was reported, as required by SFAS No. 148, “Accountingfor Stock-Based Compensation – Transition and Disclosure.”

 
| ** **                                                                                      | ** ** | **For Three  Months Ended  March 31, 2005** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
|                                                                                            |       |                                                            |       |
| Net loss attributable to common  stockholders                                                   |       | $                                                               | (1,975     | ) |
| Deduct: Total stock-based compensation  determined under fair value-based method for all awards |       | (131                                                            | )          |
| Pro forma net loss attributable to common  stockholders                                         |       | $                                                               | (2,106     | ) |
| Net loss per share attributable to common  stockholders:                                        |       |                                                            |       |
| (basic and diluted)                                                                             |       |                                                            |       |
| as reported                                                                                     |       | $                                                               | (0.33      | ) |
| pro forma                                                                                       |       | $                                                               | (0.35      | ) |
| Weighted-average shares used in  computation:                                                   |       |                                                            |       |
| Basic and diluted                                                                               |       | 6,030                                                           |       |

 

5.     Net Loss Per Share

 

Basic net loss per share iscomputed by dividing net loss attributable to common stockholders for theperiod by the weighted average number of common shares outstanding for theperiod. Diluted net loss per share is computed by dividing the net lossattributable to common stockholders by the weighted average number of commonshares and common stock equivalents outstanding for the period. Our commonstock equivalents include all common stock issuable upon conversion ofpreferred stock and the exercise of outstanding options and warrants. Theaggregate number of common stock equivalents excluded from the loss per sharecalculation for the periods ended March 31, 2006 and 2005 are 3,764,187 and 3,656,866,respectively. Our common stock equivalents are not included in the diluted lossper share for the three month periods ended March 31, 2006 and 2005, as theyare antidilutive.

 

6.     Commitments and Contingencies

 

We are subject to legalproceedings and claims that arise in the ordinary course of business. We do notbelieve that the outcome of those matters will have a material adverse affecton our consolidated financial position, operating results or cash flows. However,there can be no assurance such legal proceedings will not have a materialimpact**.**

 

7.     Preferred Stock and CommonStock

 

During the three monthsended March 31, 2006, 40,000 shares of our Series 2 5% preferred stock wereconverted into 40,000 shares of common stock and 95,872 shares of Series 3 5%preferred stock were converted into 95,872 shares of common stock. At March 31,2006, there are 259,696 shares of 5% preferred stock outstanding, 460,000shares of Series 2 5% preferred stock outstanding and 468,735 shares of Series3 5% preferred stock outstanding. In addition, an employee exercised stockoptions to purchase 834 shares of common stock during the three months endedMarch 31, 2006.

 

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Item 2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

This report containsforward-looking statements, within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934, that involve risks and uncertainties, such as statements concerning: thedifficulties in forecasting future sales caused by current economic and marketconditions, the effect of military actions on government and corporate spendingon information security products, spending patterns of, and appropriations to,U.S. government departments, the impact of our cost reduction programs and ourrefocused product line, the difficulties and uncertainties in successfullydeveloping and introducing new products, market acceptance of our products, theimpact of sustained losses on our ability to successfully operate and grow ourbusiness, our stock price and our ongoing Nasdaq eligibility, the highlycompetitive market for our products, the effects of sales and implementationcycles for our new products on our quarterly results, difficulties inaccurately estimating market growth, the consolidation of the informationsecurity industry, the impact of changing economic conditions, businessconditions in the information security industry, our ability to manageacquisitions effectively, our ability to manage discontinued operationseffectively, the impact of market peers and their products as well as risksconcerning future technology and others identified in our Annual Report on Form10-KSB and other Securities and Exchange Commission filings. Suchforward-looking statements are generally accompanied by words such as “plan,” “estimate,”“expect,” “believe,” “should,” “would,” “could,” “anticipate,” “may” or otherwords that convey uncertainty of future events or outcomes. Theseforward-looking statements and other statements made elsewhere in this reportare made in reliance on the Private Securities Litigation Reform Act of 1995. Thesection below entitled “Factors That May Affect Future Results ofOperations” sets forth and incorporates by reference certain factors that couldcause actual future results of the Company to differ materially from thesestatements.

 

Critical Accounting Policiesand Estimates

 

Management’s discussion andanalysis of financial condition and results of operations are based upon ourunaudited condensed consolidated financial statements, which have been preparedin accordance with accounting principles generally accepted in the UnitedStates. The preparation of these financial statements requires us to makeestimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities. On an on-going basis, we evaluate our estimates, includingthose related to product returns, bad debts, inventories, income taxes,warranty obligations, restructuring, maintenance contracts and contingencies. Webase our estimates on historical experience and on various other assumptionsthat we believe are reasonable under the circumstances, the results of whichform the basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources. Actual resultsmay differ from these estimates under different assumptions or conditions.

 

We believe the followingcritical accounting policies affect our more significant judgments andestimates used in the preparation of our unaudited condensed consolidatedfinancial statements.

 

*Revenue Recognition*

 

We generally recognize product revenue upon shipment of product. Weaccrue for estimated warranty costs and sales returns at the time of shipmentbased on our experience. Revenue from maintenance contracts is deferred andrecognized over the contractual period the services are performed, generallyone year. There is a risk that technical issues on new products could result inunexpected warranty costs and returns. However, as we migrate to more of asoftware-based business model, the warranty costs should continue to decline. Tothe extent that they do decline, our warranty reserve from current sales willdecrease. To the extent that our warranty costs exceed our expectations, wewill increase our warranty reserve to compensate for the additional expenseexpected to be incurred. We review these estimates periodically and determinethe appropriate reserve percentage. However, to date, warranty costs and salesreturns have not been material. Historically, our estimates for these itemshave not differed materially from actual results. Significant or subjectiveestimates associated with our revenue recognition policy include our estimateof warranty cost and sales returns.

 

We recognize software revenue from the licensing of our softwareproducts in accordance with Statement of Position (“SOP”) No. 97-2 “SoftwareRevenue Recognition”, SOP 98-9 “Modification of 97-2, Software RevenueRecognition, with respect to certain transactions” and Staff AccountingBulletin (“SAB”) No. 104, “Revenue Recognition” whereby revenue from thelicensing of our products is not recognized until all four of the followingcriteria have been met: (1) execution of a written agreement; (2) deliveryof the product has occurred; (3) the fee is fixed and determinable; and (4) collectibilityis probable. Bundled hardware and perpetual software product sales arerecognized at time of delivery, as our licenses are not sold on a subscriptionbasis. In the case of multiple product and service sales, we perform a VendorSpecific Objective Evidence analysis to appropriately determine the amount ofrevenue derived from each deliverable. If our license strategy changes and webegin to offer licenses on a subscription basis, we would perform this analysisin a similar manner. Under these circumstances, the revenue related to thelicense would be recognized ratably over the subscription period. Market valuesare easily obtained for all of our product offerings, as we have historicalsales information on our product offerings. We defer and recognize maintenanceand support revenue over the term of the contract period, which is generallyone year.

 

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We have signed distribution agreements with distributors in the UnitedStates, Europe and Asia. In general, these relationships are non-exclusive.Distributors typically maintain an inventory of our products. Under theseagreements, we provide certain protection to the distributors for theirinventory of our products for price reductions as well as products that areslow moving or have been discontinued by us. Historically, returns from ourdistributors and charges related to price reductions on inventory held bydistributors have not been material. Recognition of sales to distributors andrelated gross profits are deferred until the distributors resell themerchandise. However, since we have legally sold the inventory to thedistributor and we no longer have care, custody or control over the inventory,we recognize the trade accounts receivable and reduce inventory related to thesale at the time of shipment to the distributor. Revenue, offset by deferredcost of sales, is included in deferred revenue in the accompanying financialstatements. Since the net balance in deferred revenue represents the salesprice less the cost of the product maintained by the distributors, the deferredcosts of these products are included in our obsolescence and slow-movinganalysis and are written down according to their estimated current value. Thistransaction effectively recognizes expense for the write-down, if any, andincreases the net liability in the deferred revenue account.

 

We generally recognize service revenue upon delivery of the contractedservice. Service revenue, primarily including maintenance, training andinstallation, are recognized upon delivery of the service and typically areunrelated to product sales. These services are not essential to thefunctionality of the delivered product. To date, training and installationrevenue has not been material.

 

*Allowance for Doubtful Accounts and Returns*

 

We maintain allowances for doubtful accounts for estimated lossesresulting from the inability of our customers to make required payments. Ourreceivables are uncollaterized and we expect to continue this policy in thefuture. If the financial condition of our customers were to deteriorate,resulting in an impairment of their ability to make payments, additionalallowances may be required. Historically, our estimates for sales returns anddoubtful accounts have not differed materially from actual results.

 

*Inventory*

 

We write down our inventoryfor estimated obsolescence or unmarketable inventory equal to the differencebetween the cost of inventory and the estimated market value based uponassumptions about future demand and market conditions. If actual marketconditions are less favorable than those projected by management, additionalinventory write-downs may be required. Historically, our estimates forinventory obsolescence have not differed materially from actual results.

 

*Stock-based Compensation*

 

During the first quarter of2006, we implemented the following new critical accounting policy related toour stock-based compensation. Beginning on January 1, 2006, we began accountingfor stock options under the provisions of Financial Accounting Standards No.123 (revised 2004), “Share-Based Payment” (FAS 123(R)), which requires therecognition of the fair value of stock-based compensation. Under the fair valuerecognition provisions for FAS 123(R), stock-based compensation cost isestimated at the grant date based on the fair value of the awards expected tovest and recognized as expense ratably over the requisite service period of theaward. We have used the Black-Scholes valuation model, to estimate fair valueof our stock-based awards which requires various judgmental assumptionsincluding estimating stock price volatility, forfeiture rates, and expectedlife. Our computation of expected volatility is based on a combination ofhistorical and market-based implied volatility. In addition, we consider manyfactors when estimating expected forfeitures and expected life, including typesof awards, employee class, and historical experience. If any of the assumptionsused in the Black-Scholes model change significantly, stock-based compensationexpense may differ materially in the future from that recorded in the currentperiod.

 

We adopted FAS 123(R) usingthe modified prospective method which requires the application of theaccounting standard as of January 1, 2006. Our consolidated financial statementsas of and for the first quarter of 2006 reflect the impact of FAS 123(R). Inaccordance with the modified prospective method, the consolidated financialstatements for prior periods have not been restated to reflect, and do notinclude, the impact of FAS 123(R).

 

Results of Operations

 

The following table setsforth, for the periods indicated, certain financial data as a percentage of netrevenues. The period-to-period comparison of financial results is notnecessarily indicative of future results.

 

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| ** **                                        | ** ** | **Three  Months Ended**      | ** ** |
|---------------------------------------------------|------------|------------------------------|------------|
| ** **                                        | ** ** | **March 31, 2006** | ** ** | **March 31, 2005** | ** ** |
| Net product revenue                               |       | 49.2                         | %          | 73.5 | % |
| Net customer support and maintenance  revenue     |       | 50.8                         |       | 26.5 |   |
| Total revenue                                     |       | 100.0                        |       | 100.0 |   |
| Cost of product revenue                           |       | 30.2                         |       | 42.3 |   |
| Cost of customer support and maintenance  revenue |       | 15.3                         |       | 2.2 |   |
| Total cost of revenue                             |       | 45.5                         |       | 44.5 |   |
| Gross profit                                      |       | 54.5                         |       | 55.5 |   |
| Operating expenses:                               |       |                         |       |   |   |
| Sales and marketing                               |       | 96.0                         |       | 64.1 |   |
| Research and development                          |       | 93.1                         |       | 59.2 |   |
| General and administrative                        |       | 40.9                         |       | 19.2 |   |
| Operating loss                                    |       | (175.4                       | )          | (87.0 | ) |
|                                              |       |                         |       |   |   |
| Interest income, net                              |       | 2.1                          |       | 0.3 |   |
| Loss before income tax provision                  |       | (173.3                       | )          | (86.7 | ) |
|                                              |       |                         |       |   |   |
| Income tax provision                              |       | —                       |       | — |   |
|                                              |       |                         |       |   |   |
| Net loss                                          |       | (173.3                       | )%         | (86.7 | )% |
| Preferred stock dividends accrued                 |       | (5.3                         | )          | (2.4 | )  |
| Beneficial conversion feature on preferred  stock |       | —                       |       | (77.6 | )  |
|                                              |       |                         |       |   |   |
| Net loss attributable to common  stockholders     |       | (178.6                       | )%         | (166.7 | )% |

 
| ** **          | ** ** | **Three Months Ended** | ** ** |
|---------------------|------------|----------------------------------|------------|
| ** **          | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005** | ** ** |
| Domestic revenues   |       | 85.8                             | %          | 86.1 | % |
| Export revenues to: |       |                             |       |   |   |
| Europe              |       | 8.1                              |       | 7.6 |   |
| Canada              |       | 3.4                              |       | 0.1 |   |
| Asia                |       | 2.5                              |       | 6.1 |   |
| Latin America       |       | 0.2                              |       | 0.1 |   |
|                |       |                             |       |   |   |
| Net revenues        |       | 100.0                            | %          | 100.0 | % |

 

**NetRevenues**. Netrevenues for the quarter ended March 31, 2006 were $0.9 million, compared to$1.2 million for the same period in 2005. Product revenues decreased $0.5million for the quarter ended March 31, 2006 compared to the same period in 2005.Customer support and maintenance revenue increased $0.1 million for the quarterended March 31, 2006 compared to the same period in 2005. Consistent with ourstrategic move to concentrate on our intrusion prevention/detection, entityidentification and regulated information compliance and data privacy products,total revenues (including maintenance and support) for the quarter ended March31, 2006 from these products decreased to $0.8 million from $1.2 million forthe same period in 2005.

 

**Concentrationof Revenues**. Revenuesfrom sales to various U.S. government entities totaled $0.6 million, or 66.8%of revenues, for the quarter ended March 31, 2006 compared to $0.7 million, or 62.8%of revenues, for the same period in 2005. Although, we expect our concentrationof revenues to vary among customers in future quarters depending upon thetiming of certain sales, we anticipate that sales to government customers willcontinue to account for a significant portion of our revenues in futurequarters. Sales to the government present risks in addition to those involvedin sales to commercial customers which could adversely affect our revenues,including potential disruption to appropriation and spending patterns and thegovernment’s reservation of the right to cancel contracts and purchase ordersfor its convenience. Although we do not believe that the cancellation of anyparticular order would have a material adverse effect on our financial resultsor that any of our revenues with government customers are subject torenegotiation, a large number of cancelled or renegotiated government orderscould have a material adverse effect on our financial results. Currently, weare not aware of any proposed cancellation or renegotiation of any of our existingarrangement with government entities and, historically, government entitieshave not cancelled or renegotiated orders which had a material adverse effecton our business.

 

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**GrossProfit**. Grossprofit was 0.5 million or 54.5% of net revenues for the quarter ended March 31,2006, compared to $0.7 million or 55.5% of net revenues for the same period in2005. Gross profit margins as a percentage of net revenues decreased from thesame period in the prior year due to a decline in sales volume. Gross profit onproduct revenues for the quarter ended March 31, decreased from 42.5% in 2005to 38.5% in 2006 due to the decline in sales volume. Gross profit on customersupport and maintenance revenues for the quarter ended March 31, decreased from91.7% in 2005 to 70.0% in 2006.

 

Gross profit as a percentageof net revenues is impacted by several factors, including shifts in productmix, changes in channels of distribution, revenue volume, fluctuations inthird-party assembly costs, pricing strategies, and fluctuations in revenues ofintegrated third-party products.

 

**Sales andMarketing**. Salesand marketing expenses remained constant at $0.8 million for the quarters endedMarch 31, 2006 and 2005. Sales and marketing expenses may vary in the future. However,we believe that these costs will remain relatively constant through the end of 2006.

 

**Researchand Development**. Researchand development expenses increased to $0.8 million for the quarter ended March31, 2006 from $0.7 million for the same period in 2005. Research anddevelopment costs are expensed in the period incurred. Research and developmentexpenses increased in the three months ended March 31, 2006, compared to thesame period in 2005 primarily due to stock-based compensation expense totaling$43 thousand recognized in 2006 under SFAS123(R). Research and developmentexpenses may vary in the future; however, we believe that these costs willremain relatively constant through the end of 2006.

 

**General andAdministrative**. Generaland administrative expenses increased to $0.3 million for the quarter endedMarch 31, 2006, compared to $0.2 million for the quarter ended March 31, 2005primarily due to stock-based compensation expense totaling $62 thousandrecognized in 2006 under SFAS123(R). It is expected that general andadministrative expenses will remain relatively constant throughout theremainder of 2006, as no further headcount reductions are anticipated. Generaland administrative expense may vary in the future.

 

**Interest**. Net interest income increased to $18thousand for the quarter ended March 31, 2006 compared to $4 thousand for thesame period in 2005. The increase in interest income was primarily due tobetter returns over prior year and an increase of cash and short-terminvestment balances when compared to prior year. Net interest income may varyin the future based on our cash flow and rate of return on investments.

 

Liquidity and CapitalResources

 

Our principal source ofliquidity at March 31, 2006 is approximately $1.1 million of cash and cashequivalents and $0.5 million of short-term investments. At March 31, 2006working capital was $1.4 million compared to $3.9 million at March 31, 2005.

 

Cash used inoperations for the three months ended March 31, 2006 was $1.7 million,primarily due to a net loss of $1.5 million, a decrease in accounts payable andaccrued expenses of $0.2 million, a reduction in deferred revenue of $0.2million, an increase in accounts receivable of $0.1 million and a reduction inthe provision for doubtful accounts of $13 thousand. This cash decrease waspartially offset by stock-based compensation of $0.2 million, depreciationexpense of $36 thousand, a decrease in inventories of $25 thousand and adecrease in prepaid expenses and other assets of $6 thousand. Cash usedin operations for the three months ended March 31, 2005 was $0.6 million,primarily due to an operating loss of $1.0 million, a decrease in accountspayable and accrued expenses of $0.3 million and a decrease in the provisionfor doubtful accounts of $0.1 million. This cash usage was partially offset bydepreciation and amortization of $39 thousand, a decrease in accountsreceivable of $0.7 million, a decrease in inventories of $0.1 million and adecrease in other assets of $33 thousand. Future fluctuations ininventory balances, accounts receivable and accounts payable will be dependentupon several factors, including, but not limited to, quarterly sales, ourstrategy in building inventory in advance of receiving orders from customers,and the accuracy of our forecasts of product demand and component requirements.

 

There was no cash used ininvesting activities in the three months ended March 31, 2006, compared to cashused in investing activities in the three months ended March 31, 2005 of $0.4million, which consisted primarily of the net purchase of short-terminvestments of $0.3 million and net purchases of property and equipment of $0.1million.

 

Cash used in financingactivities in the three months ended March 31, 2006 was $46 thousand, primarilyconsisting of the payment of dividends on preferred stock, compared to cashprovided by financing activities in the three months ended March 31, 2005 was $2.5million, consisting of net financing proceeds from a private placement of $2.5million, partially offset by payment of dividends on preferred stock of $35thousand.

 

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At March 31, 2006, theCompany did not have any material commitments for capital expenditures.

 

During the three monthsended March 31, 2006, the Company funded its operations through the use of cashand cash equivalents.

 

As of March 31, 2006, we hadcash, cash equivalents and short-term investments in the amount ofapproximately $1.6 million, down from approximately $3.3 million as ofDecember 31, 2005. We funded our operations and met our cash requirementsduring the three months ended March 31, 2006 through the use of cash and cashequivalents. On March 29, 2006, we established a $1.0 million line of creditwith Silicon Valley Bank. Our existing cash resources, line of credit andprojections for increased revenues for the remainder of 2006, may not provide sufficientcash resources to finance our operations and expected capital expenditures forthe next twelve months. It is likely that we will need to seek additional debtor equity financing to fund our operations for the next year. The sufficiency of our cash resources dependto a certain extent on general economic, financial, competitive or other factorsbeyond our control. Moreover, despite actions to reduce our costs and improveour profitability, our operating losses and net operating cash outflows willcontinue through at least the second quarter of 2006. As a result, we may notbe able to achieve the revenue and gross margin objectives necessary to achievepositive cash flow or profitability without obtaining additional equity financing.We do not currently have any arrangements for additional financing and we maynot be able to secure additional debt or equity financing on terms acceptableto us, or at all, at the time when we need such funding. Additionally, we maynot have sufficient availability under our credit line when additional fundsare needed. Furthermore, because our stockholders’ equity of $1.7 million as ofMarch 31, 2006 is less than the $2.5 million required by Nasdaq, we must raiseadditional cash or increase our sales in order to maintain the listing of ourcommon stock on The Nasdaq Capital market. If our business does notgenerate sufficient cash flow from operations and sufficient future financingsare not available, we may not be able to operate or grow our business, pay ourexpenses when due, fund our other liquidity needs or maintain our listing onThe Nasdaq Capital Market. Moreover,any financing raised by us may restrict our business activities for futurecapital raising efforts or cause dilution to our current stockholders.

 

We may explore the possibleacquisitions of businesses, products and technologies that are complementary toour existing business. We are continuing to identify and prioritize additionalsecurity technologies, which we may wish to develop, either internally orthrough the licensing, or acquisition of products from third parties. While wemay engage from time to time in discussions with respect to potentialacquisitions, there can be no assurances that any such acquisitions will bemade or that we will be able to successfully integrate any acquired business. Inorder to finance such acquisitions and working capital it may be necessary forus to raise additional funds through public or private financings. Any equityor debt financings, if available at all, may be on terms, which are notfavorable to us and, in the case of equity financings, may result in dilutionto our stockholders.

 

Off-Balance SheetArrangements.

 

As of March 31, 2006, we didnot have any significant off-balance sheet arrangements, as defined by Item303(c)(2) of Regulation S-B.

 

Factors That May AffectFuture Results of Operations 

 

Numerous factors may affectour business and future results of operations. These factors include currenteconomic and market conditions, the effect of military actions on governmentand corporate spending on information security products, spending patterns of,and appropriations to, U.S. government departments, technological changes,competition and market acceptance, acquisitions, product transitions, timing oforders, manufacturing and suppliers, reliance on outsourcing vendors and otherpartners, intellectual property and licenses, third-party products, dependenceon government customers, international operations, intellectual propertyissues, liquidity and cash resources and effects of restructuring plans andcost reductions. The discussion below addresses some of these and other factors.For a more thorough discussion of these and other factors that may affect ourbusiness and future results, see the discussion under the caption “Factors ThatMay Affect Future Results of Operations” in our Annual Report on Form 10-KSBfor the year ended December 31, 2005.

 

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***Our cash, cash equivalents, andinvestments decreased from $3.3 million at December 31, 2005 to $1.6million at March 31, 2006 due to results of operations. If our net cashoutflows continue, we may not have sufficient cash to operate our business andmay not be able to maintain our Nasdaq listing.***

 

As ofMarch 31, 2006, we had cash, cash equivalents and investments in theamount of approximately $1.6 million, down from approximately $3.3 million asof December 31, 2005. Our existing cash resources, line of credit andprojections for increased revenues for the remainder of 2006, may not providesufficient cash resources to finance our operations and expected capitalexpenditures for the next twelve months. It is likely that we will need to seekadditional debt or equity financing to fund our operations for the next year. Thesufficiency of our cash resources depend to a certain extent on generaleconomic, financial, competitive or other factors beyond our control. Moreover,despite actions to reduce our costs and improve our profitability, ouroperating losses and net operating cash outflows will continue through at leastthe second quarter of 2006. As a result, we may not be able to achieve therevenue and gross margin objectives necessary to achieve positive cash flow orprofitability without obtaining additional equity financing. We do notcurrently have any arrangements for additional financing and we may not be ableto secure additional debt or equity financing on terms acceptable to us, or atall, at the time when we need such funding. If our business does notgenerate sufficient cash flow from operations and sufficient financingresources are not available, we may not be able to operate or grow ourbusiness, pay our expenses when due or fund our other liquidity needs. We maynot have sufficient availability under our credit line when we need additionalfunds. Furthermore, we may not be able to secure additional debt or equityfinancing on terms that are acceptable to us, or at all, on a timely basis. Therefore,if our business does not generate sufficient cash flow from operations andsufficient financing resources are not available, we may not be able to operateor grow our business, pay our expenses when due or fund our other liquidityneeds.

 

***If we fail to comply with Nasdaq’s stockholders’ equity requirement,our common stock will be subject to delisting which could adversely effect theprice and liquidity of our shares.***

 

The NasdaqCapital Market maintains certain minimum requirements to maintain the Nasdaqlisting of our common stock. In particular, Nasdaq Marketplace Rule4320(c)(2)(B) requires us to have at least one of (1) $2,500,000 instockholders’ equity, (2) $35,000,000 market value of listed securities or (3)$500,000  of net income from continuingoperations for the most recently completed fiscal year or two of the three mostrecently completed fiscal years. As of March 31, 2006, our stockholders’ equitywas approximately $1,657,000, and as of May 4, 2006, the market value of ourcommon stock was approximately $9,583,000 based on 7,046,213 shares outstandingand a closing price of $1.36 per share. In addition, we have reported netlosses from continuing operations in each of the last three most recentlycompleted fiscal years.

 

As a result,we do not currently comply with Nasdaq’s continued listing requirements. Furthermore,although we are currently exploring a range of alternatives to increasethe amount of our cash, we may not be able to complete an alternativetransaction on acceptable terms, if at all, and may not be able to regaincompliance with these requirements. Therefore, Nasdaq may seek to delist ourshares of common stock from The Nasdaq Capital Market. In that event, ourcommon stock likely would trade in a less efficient market such as the OTCBulletin Board or in the “pink sheets” maintained by the National QuotationBureau, Inc. Furthermore, our common stock may become subject to the “pennystock” rules adopted by the SEC which impose additional sales pricerequirements on broker dealers who sell our shares. Consequently, the delistingof our common stock may adversely impact our stock price, the liquidity of ourcommon stock and our general business reputation.

 

***If we fail to respond to rapid technological changes in the networksecurity, data protection, regulated information compliance, entityidentification and spyware prevention industries, we may lose customers or ourproducts may become obsolete.***

 

The network security, dataprotection, regulated information compliance, entity identification and spywareprevention industries are characterized by frequent product introductions,rapidly changing technology and continued evolution of industry standards. Wemust introduce upgrades to our products rapidly in response to customer needs,such as new computer viruses or other novel external attacks on computernetworks as well as the adoption privacy and data protection laws. In addition,the nature of the network security, data protection, regulated informationcompliance, entity identification and spyware prevention industries requiresour products to be compatible and interoperable with numerous securityproducts, networking products, workstation and personal computer architecturesand computer and network operating systems offered by various vendors,including our competitors. As a result, our success depends upon our ability todevelop and introduce in a timely manner new products and enhancements to ourproducts that meet changing customer requirements and evolving industry andlegal standards. The development of technologically advanced network security,data protection, regulated information compliance, entity identification andspyware prevention products is a complex and uncertain process requiring highlevels of innovation, rapid response and accurate anticipation of technologicaland market trends. We cannot assure you that we will be able to identify,develop, manufacture, market or support new or enhanced productssuccessfully in a timely manner. Further, the introduction of new products orproduct enhancements by us or our competitors or the adoption of new or amendedprivacy or data protection laws may shorten the life cycle of our existingproducts or cause our existing products to become obsolete.

 

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***Our revenues have decreased to$0.9 million for the first three months of 2006 from $1.2 million for the sameperiod in 2005 and have generally decreased since 2003 in connection with ashift to sales of our newer product lines. If our network intrusion detection,regulated information compliance, spyware prevention and entity identificationproducts do not achieve market acceptance, our revenues will suffer.***

 

We have continued totransition our sales strategy from our lower margin SecureCom and PDS securityappliance products to the development and sales of our higher margin networkintrusion detection/prevention, regulated information compliance, entityidentification and spyware products. During this transition, sales of our newproducts were not enough to counteract the loss in sales associated with ourolder products. As a result, our net revenues remained relatively constant atapproximately $6.0 million in 2004 and 2005 but have declined in the firstquarter 2006 compared to the same period in 2005 due to a longer than expectedsales cycle.

 

Our new network securityproducts, regulated information compliance systems, entity identification andspyware products have only been in the market place for a limited period oftime and may have longer sales cycles than our previous products. Althoughresponse to our products has been positive, we have not yet received broadmarket acceptance. We cannot assure you that our present or future productswill achieve market acceptance on a sustained basis.

 

In order to achievemarket acceptance and achieve future revenue growth, we must introducecomplementary security products, incorporate new technologies into our existingproduct lines and design, develop and successfully commercialize higherperformance products in a timely manner. We cannot assure you that we will beable to offer new or complementary products that gain market acceptance quicklyenough to avoid decreased revenues during current or future productintroductions or transitions.

 

***We resemble a developmental stage company and our business strategy maynot be successful.***

 

From our founding in 1983until 2000, we derived substantially all of our revenue from the design,manufacture and sale of local area networking equipment. In order to permit usto focus our resources solely on developing and marketing our network securityproducts, we sold our local area networking assets and related networkingdivisions in a series of sales from 2000 to 2002.

 

As a result of these sales,we now depend exclusively on revenues generated from the sale of our networksecurity products, which have received limited market acceptance. Moreover, wehave only recently introduced our regulated compliance and data privacy systemsand our spyware prevention and entity identification products. Although initialresponse to these products has been positive, the market for these products hasonly begun to emerge and sales of these products may not occur as quickly as weexpect. Consequently, we resemble a developmental stage company and will facethe following inherent risks and uncertainties:

 

•      the need for our network security products,regulated information compliance systems, data privacy protection systems,entity identification products and spyware prevention products to achievemarket acceptance and produce a sustainable revenue stream;

 

•      our ability to manage costs and expenses;

 

•      our dependence on key personnel;

 

•      our ability to obtain financing on acceptableterms; and

 

•      our ability to offer greater value than ourcompetitors.

 

Our business strategy maynot successfully address these risks. If we fail to recognize significantrevenues from the sales of our network security products and regulatedinformation compliance systems, our business, financial condition and operatingresults would be materially adversely affected.

 

***We incurred a net loss of $1.5 million for the three months ended March31, 2006 and have an accumulated deficit of $53.5 million as of March 31, 2006.As a result, we must generate substantially greater revenues from sales inorder to achieve profitability.***

 

We have incurred significantoperating losses and are uncertain about our future operating results. For the threemonths ended March 31, 2006, we incurred a net loss of $1.5 million and had anaccumulated deficit of approximately $53.5 million as of March 31, 2006. Weneed to generate and sustain substantially greater revenues from the sales ofour products if we are to achieve profitability. If we are unable to achievethese greater revenues, our losses will continue indefinitely, and we may neverachieve or sustain profitability or generate positive cash flow.

 

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***We face intense competition from both start-up and establishedcompanies that may have significant advantages over us and our products.***

 

The market for networksecurity solutions is intensely competitive. There are numerous companiescompeting with us in various segments of the data security markets, and theirproducts may have advantages over our products in areas such as conformity toexisting and emerging industry standards, interoperability with networking andother security products, management and security capabilities, performance,price, ease of use, scalability, reliability, flexibility, product features andtechnical support.

 

Our principal competitors in the network intrusion prevention anddetection market include Internet Security Systems, Inc., CiscoSystems, Inc., Symantec, Inc., Netscreen Technologies, Inc., NetworkAssociates, Inc., Tipping Point Technologies, a division of 3Com Corporation,and NFR Security, Inc. Our competitors in the regulated information compliancemarket include Vontu, Port Authority, Vericept, Reconnex, Tablus and a smallnumber of start-up companies that entered the space within the last two years.Regarding the spyware prevention market, we currently directly and indirectlycompete with a number of host-based spyware detection systems, such asAd-Aware, Spybot S&D and Spy Sweeper and some inline proxy solutions suchas Blue Coat Systems, Inc. Our current and potential competitors may have oneor more of the following significant advantages over us:

 

•     greater financial, technical and marketingresources;

 

•      better name recognition;

 

•      more comprehensive security solutions;

 

•      better or more extensive cooperativerelationships; and

 

•      larger customer base.

 

Although we believe ourproducts compare favorably to our competitors’ products and create asustainable business model, we cannot assure you that our products will achievemarket acceptance or that we will be able to compete successfully with ourexisting or new competitors.

 

***Military actions may disrupt our business by reducing spending ourproducts, increasing our costs and affecting our international operations.***

 

We derive a substantialportion of our revenue from sales to United States government entities,including sales to various Army andother armed****services bases.As a result, United States military actions or other events occurring inresponse to or in connection with them, including future terrorist attacks,actual conflicts involving the United States or its allies or military or tradedisruptions could impact our operations by:

 

•     reducing or delaying government, armedservice or corporate spending on our products;

 

•     increasing the cost and difficulty inobtaining materials or shipping products; and

 

•     affecting our ability to conduct businessinternationally.

 

Should these events occur,our business, operating results and financial condition could be materially andadversely affected.

 

***Our products can have long sales and implementation cycles, which mayresult in us incurring substantial expenses before realizing any associatedrevenues.***

 

The sale and implementationof our products to large companies and government entities typically involves alengthy education process and a significant technical evaluation and commitmentof capital and other resources. This process is also subject to the risk ofdelays associated with customers’ internal budgeting and other procedures forapproving capital expenditures, deploying new technologies within theirnetworks and testing and accepting new technologies that affect key operations.As a result, sales and implementation cycles for our products can be lengthy,and we may expend significant time and resources before we receive any revenuesfrom a customer or potential customer. Our quarterly and annual operatingresults could be materially harmed if orders forecasted for a specific customerfor a particular period are not realized.

 

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***Our failure torealize the expected benefits of our recent restructuring efforts couldadversely affect our operating results.***

 

Since we beganrestructuring in 2002, we have incurred approximately $1.1 million inrestructuring charges, severance, and related expenses. The objective of ourrestructuring plan was to reduce our cost structure to a sustainable level thatis consistent with our current cash resources and the general economic climate.We have also implemented other strategic initiatives to strengthen ouroperations, such as reductions in our work force and facilities and aligningour organization around our business objectives. Any further work forcereductions could result in temporary reduced productivity of our remainingemployees. Additionally, our customers and prospects may delay or forgopurchasing our products due to a perceived uncertainty caused by ourrestructuring and other changes. Failure to achieve the desired results of ourinitiatives could seriously harm our business, results of operations andfinancial condition.

 

***Consolidation inthe network security industry may limit market acceptance of our products.***

 

Several of ourcompetitors have acquired security companies with complementary technologies inthe past. We expect consolidation in the network security industry to continuein the future. These acquisitions may permit our competitors to accelerate thedevelopment and commercialization of broader product lines and morecomprehensive solutions than we currently offer. Acquisitions of vendors orother companies with which we have a strategic relationship by our competitorsmay limit our access to commercially significant technologies. Further,business combinations in the network security industry are creating companieswith larger market shares, customer bases, sales forces, product offerings andtechnology and marketing expertise, which may make it more difficult for us tocompete.

 

***Sales to government entities accounted for 66.8% of our revenues for thethree months ended March 31, 2006 and 70.7% of our revenues for the year endedDecember 31, 2005. Sales to government customers involve unique risks,which could adversely impact our revenues.***

 

We derived 66.8% of ourrevenues from sales to various U.S. government entities for the three monthsended March 31, 2006, and 70.7% of our revenues from these sales for the yearended December 31, 2005. We expect to continue to derive a substantialportion of our revenues from U.S. government customers in the future. Sales tothe government present risks in addition to those involved in sales to commercialcustomers, including potential disruption due to appropriation and spendingpatterns and the government’s right to cancel contracts and purchase orders forits convenience. General political and economic conditions, which we cannotaccurately predict, may affect the quantity and allocation of expenditures byfederal departments. In addition, obtaining government contracts may involvelong purchase and payment cycles, competitive bidding, qualificationrequirements, delays or changes in funding, budgetary constraints, politicalagendas, extensive specification development and price negotiations andmilestone requirements. Each government entity also maintains its own rules andregulations with which we must comply and which can vary significantly among departments.As a result, cutbacks or re-allocations in the federal budget or losses ofgovernment sales due to other factors could have a material adverse effect onour revenues and operating results.

 

***We derived 14.2% of our revenues from international sales in the threemonths ended March 31, 2006, and 10.7% of our revenues from these sales for theyear ended December 31, 2005. Our ability to sell our productsinternationally is subject to certain risks which could harm our business.***

 

Sales to foreign customersaccounted for approximately 10.7% of our revenues for the year endedDecember 31, 2005, and 14.2% of our revenues for the three months ended March31, 2006. We expect sales to foreign customers to continue to represent asignificant portion of our revenues in the future. Our international operationsare subject to many inherent risks that may adversely affect our business,financial condition and operating results, including:

 

•      political, social and economic instability;

 

•      trade restrictions;

 

•      increases in duty rates and other potentiallyadverse tax consequences;

 

•      exposure to different legal standards,particularly with respect to the protection of intellectual property;

 

•      burdens of complying with a variety offoreign laws;

 

•      unexpected changes in regulatoryrequirements;

 

•      import and export license requirements andrestrictions of the United States and each other country where we operate;

 

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•      fluctuations in currency exchange rates; and

 

•      changes in local purchasing practices,including seasonal fluctuations in demand.

 

***Sales through indirect channels accounted for 15.5% of our revenues forthe three months ended March 31, 2006 and 36.2% of our revenue for the yearended December 31, 2005. Our revenues will suffer if we do not expand oursales through, or receive the anticipated benefits from our sales through,indirect sales channels.***

 

We derived 15.5% of ourrevenues for the three months ended March 31, 2006, and 36.2% of our revenuefor the year ended December 31, 2005, from sales through indirect saleschannels, such as distributors, value added resellers, system integrators,original equipment manufacturers and managed service providers. We believe wemust expand our sales through these indirect channels in order to increase ourrevenues. Although we are actively pursuing a strategy to increase thepercentage of our revenues generated through these indirect sales channels, we cannotassure you that our products will gain market acceptance in these indirectsales channels or that sales through these indirect sales channels willincrease our revenues as expected. Further, many of our competitors are alsotrying to sell their products through these indirect sales channels, whichcould result in lower prices and reduced profit margins for sales of ourproducts.

 

***We must adequately protect our intellectual property in order toprevent loss of valuable proprietary information.***

 

We rely on a combination ofpatent, copyright, trademark and trade secret laws, confidentiality proceduresand non-disclosure agreements to protect our proprietary technology. However,unauthorized parties may attempt to copy or reverse engineer aspects of ourproducts or to obtain and use information that we regard as proprietary. Policingunauthorized use of our products is difficult, and we cannot be certain thatthe steps we have taken will prevent misappropriation of our intellectualproperty. This is particularly true in foreign countries where the laws may notprotect proprietary rights to the same extent as the laws of the United Statesand may not provide us with an effective remedy against unauthorized use. Ifour protection of our intellectual property proves to be inadequate orunenforceable, others may be able to use our proprietary developments withoutcompensation to us, resulting in potential cost advantages to our competitors.

 

***We may incur substantial expenses defending ourselves against claims ofinfringement.***

 

There are numerous patentsheld by many companies relating to the design and manufacture of networksecurity systems. Although we are not aware of any instances in which ourproducts violate the intellectual property rights of others or inappropriatelyuse their technology, it is possible that third parties in the future may claimthat our products infringe on their intellectual property rights. Any claim,with or without merit, could consume our management’s time, result in costlylitigation, cause delays in sales or implementations of our products or requireus to enter into royalty or licensing agreements. Royalty and licensingagreements, if required and available, may be on terms unacceptable to us ordetrimental to our business. Moreover, a successful claim of productinfringement against us or our failure or inability to license the infringed orsimilar technology on commercially reasonable terms could seriously harm ourbusiness.

 

***Fluctuations in our quarterly revenues may cause the price of ourcommon stock to decline.***

 

Our operating results have variedsignificantly from quarter to quarter in the past, and we expect our operatingresults to vary from quarter to quarter in the future due to a variety offactors, many of which are outside of our control. Although our revenues aresubject to fluctuation, significant portions of our expenses are not variablein the short term, and we cannot reduce them quickly to respond to decreases inrevenues. Therefore, if revenues are below our expectations, this shortfall islikely to adversely and disproportionately affect our operating results. Accordinglywe may not attain positive operating margins in future quarters. Any of thesefactors could cause our operating results to be below the expectations ofsecurities analysts and investors, which likely would negatively affect theprice of our common stock.

 

***The price of our common stock has been volatile in the past and maycontinue to be volatile in the future due to factors outside of our control.***

 

The market price of ourcommon stock has been highly volatile in the past and may continue to bevolatile in the future. For example, for the three-month period ending March31, 2006, the market price of our common stock on The Nasdaq Capital Marketfluctuated between $1.28 and $2.87 per share. The market price of our commonstock may fluctuate significantly in response to a number of factors, many ofwhich are outside our control, including:

 

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•     variations in our quarterly operatingresults;

 

•      changes in estimates of our financialperformance by securities analysts;

 

•      changes in market valuations of ourcompetitors;

 

•      announcements by us or our competitors of newproducts, significant contracts, acquisitions, strategic relationships, jointventures or capital commitments;

 

•      product or design flaws, product recalls orsimilar occurrences;

 

•      additions or departures of key personnel;

 

•      sales of common stock in the future; and

 

•      fluctuations in stock market prices andvolume, which can be particularly common among network security and other hightechnology companies.

 

***Our reductions in our work force may make it more difficult for us toattract and retain the personnel necessary to successfully operate ourbusiness.***

 

We rely upon the continuedservice of a relatively small number of key technical, sales and seniormanagement personnel. Our future success depends on retaining our key employeesand our continuing ability to attract, train and retain other highly qualifiedtechnical, sales and managerial personnel. As a result, our employees couldresign with little or no prior notice. We may not be able to attract,assimilate or retain other highly qualified technical, sales and managerialpersonnel in the future, especially given our recent reductions in force. Theloss of any of our key technical, sales and senior management personnel or ourinability to attract, train and retain additional qualified personnel couldseriously harm our business.

 

***Certain rights of the holders ofour preferred stock and the terms of our secured credit line may hinder ourability to raise additional financing.***

 

We cannot issue shares ofcapital stock with rights senior to those of our existing 5% preferred stock,Series 2 5% preferred stock or Series 3 5% preferred stock without the approvalof at least a majority of the holders of our 5% preferred stock, all of theholders of our Series 2 5% preferred stock, and holders of at least 75% of ourSeries 3 5% preferred stock voting or acting as separate classes. We alsocannot incur certain indebtedness without the approval of at least a majorityof the holders of our 5% preferred stock. In addition, holders of the Series 35% preferred stock who are not executive officers or directors have the rightto purchase a pro rata portion of certain future issuances of securities by us.Furthermore, the terms of our secured credit line with Silicon Valley Bankinclude covenants which restrict our ability to incur additional debt and paycertain dividends. The combination of these provisions could hinder or delayour ability to raise additional debt or equity financing.

 

***You will experience substantial dilution upon the conversion orredemption of the shares of preferred stock and exercise of warrants that weissued in recent private placements.***

 

On March 25, 2004, wecompleted a $5,000,000 private placement in connection with which we issued1,000,000 shares of our 5% Convertible Preferred Stock and warrants to acquire556,619 shares of our common stock. The conversion price for the preferredstock and the exercise price of the warrants is $3.144 per share. We alsoissued our placement agent a warrant for 64,408 shares of our common stock atan exercise price of $3.144 per share. As of May 1, 2006, there were 259,696shares of 5% preferred stock, representing approximately 413,003 shares ofcommon stock upon conversion, and warrants to purchase 621,027 shares of commonstock outstanding.

 

In addition, on March 28,2005, we completed a $2,663,000 private placement in connection with which weissued 1,065,200 shares of our Series 2 5% Convertible Preferred Stock andwarrants to acquire 532,600 shares of our common stock. We also issued twoaffiliates of our placement agent warrants to purchase an aggregate of 60,390shares of common stock. The conversion price for the preferred stock is $2.50per share and the exercise price of the warrants is $2.77 per share. As of May 1,2006, there were 460,000 shares of Series 2 5% preferred stock, representing460,000 shares of common stock upon conversion, and warrants to purchase 592,990shares of common stock outstanding.

 

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Finally, on December 2,2005, we completed a $1,230,843 private placement in connection with which weissued 564,607 shares of our Series 3 5% preferred stock and warrants toacquire 282,306 shares of our common stock. We also issued two affiliates ofour placement agent warrants to purchase an aggregate of 27,531 shares ofcommon stock. The conversion price of the preferred stock is $2.18 per shareand the exercise price of the warrants is $2.58 per share. As of May 1, 2006,there were 468,735 shares of Series 3 5% preferred stock, representing 468,735shares of common stock upon conversion, and warrants to purchase 309,837 sharesof common stock outstanding.

 

On May 1, 2006, we had7,046,213 shares of common stock outstanding. We expect the private placementsdiscussed above to result in a further dilution to holders of our common stockupon conversion of the preferred stock and exercise of the warrants of2,865,592 shares of common stock, or an approximately 40.7% increase in thenumber of shares of our common stock outstanding.

 

Further, the occurrenceof certain events entitle holders of our Series 3 5% preferred stock to requireus to redeem their shares for a number of shares of our common stock equal tothe redemption price divided by 75% of the ten-day average of the volumeweighted average price of our common stock ending on the day immediatelypreceding the holder’s election to redeem, subject to a floor of $0.87 pershare. Holders of our Series 2 5% preferred stock have similar redemptionrights without a floor. The redemption price for the shares of Series 3 5%preferred stock equals the sum of (1) the greater of $2.834 and the volumeweighted average price of our common stock on the trading day immediatelypreceding the redemption event multiplied by $2.18 divided by the conversionprice of the Series 3 5% preferred stock then in effect plus (2) any accruedbut unpaid dividends on the Series 3 5% preferred stock plus (3) anyunpaid liquidated damages or other amounts payable to the holders of the Series3 5% preferred stock. The redemption price for the shares of Series 2 5%preferred stock equals the sum of (1) the greater of $3.25 and the volume weightedaverage price of our common stock on the trading day immediately preceding theredemption event multiplied by $2.50 divided by the conversion price of theSeries 2 5% preferred stock then in effect plus (2) any accrued but unpaiddividends on the Series 2 5% preferred stock plus (3) any unpaidliquidated damages or other amounts payable to the holders of the Series 2 5%preferred stock. As a result, assuming we have paid all liquidated damages andother amounts to the holders, accrued but unpaid dividends on April 28, 2006 of$17,554, a volume weighted average price of $1.37, which was the ten-day volumeweighted average closing price of our common stock on April 28, 2006, and our7,046,213 shares of common stock outstanding on April 28, 2006, we would issueapproximately 2,764,914 shares of our common stock if a specified redemptionevent occurs and all holders of Series 3 5% preferred stock and Series 2 5%preferred stock elected to redeem their shares for common stock. This wouldrepresent an increase of approximately 39.2% in the number of shares of ourcommon stock as of April 28, 2006.

 

***The conversion of preferred stock or exercise of warrants we issued inour recent private placement may cause the price of our common stock todecline.***

 

The holders of the sharesof our 5% preferred stock and warrants we issued on March 25, 2004, mayfreely convert their shares of preferred stock and exercise their warrants andsell the underlying shares of common stock pursuant to an effectiveregistration statement we filed on August 6, 2004. As of May 1, 2006,740,304 shares of preferred stock had converted into 1,177,327 shares of commonstock.

 

The holders of the sharesof Series 2 5% preferred stock and warrants we issued on March 28, 2005,may freely convert their shares of preferred stock and exercise their warrantsand sell the underlying shares of common stock pursuant to an effectiveregistration statement we filed on May 5, 2005. As of May 1, 2006, 605,200shares of Series 2 5% preferred stock had converted into 605,200 shares ofcommon stock.

 

The holders of the sharesof Series 3 5% preferred stock and warrants we issued on December 2, 2005, mayfreely convert their shares of preferred stock and exercise their warrants andsell the underlying shares of common stock pursuant to an effectiveregistration statement we filed on January 5, 2006. As of May 1, 2006, 95,872shares of Series 3 5% preferred stock had converted into 95,872 shares ofcommon stock.

 

For the four weeks endedon April 28, 2006, the average daily trading volume of our common stock on TheNasdaq Capital Market was 16,332 shares. Consequently, if holders of preferredstock or warrants elect to convert their remaining shares or exercise theirwarrants and sell a material amount of their underlying shares of common stockon the open market, the increase in selling activity could cause a decline inthe market price of our common stock. Furthermore, these sales, or thepotential for these sales, could encourage short sales, causing additional downwardpressure on the market price of our common stock.

 

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***The payment ofaccrued dividends on our preferred stock may strain our cash resources.***

 

Shares of our 5%preferred stock accrue cash dividends equal to $0.25 per share per annum,payable in arrears on March 31 and September 30 of each year, shares of ourSeries 2 5% preferred stock accrue cash dividends equal to $0.125 per share perannum, payable in arrears on the first business day of March, June, Septemberand December of each year and shares of our Series 3 5% preferred stock accruecash dividends equal to $0.109 per share per annum, payable in arrears on thefirst business day of March, June, September and December of each year. Theamount of the dividends on our Series 2 5% preferred stock may increase to$0.45 per share per annum and the amount of the dividends on our Series 3 5%preferred stock may increase to $0.3294 per share per annum upon the occurrenceof certain event entitling the holders of these shares to redemption.

 

During 2005, we paid $123thousand in dividends related to our 5% convertible preferred stock and $63thousand in dividends related to our Series 2 5% preferred stock. At March 31,2006, we had $33,526 dividends accrued related to our 5% preferred stock,$4,884 related to our Series 2 5% preferred stock and $4,339 related toour Series 3 5% preferred stock.

 

Delaware law providesthat we may only pay dividends out of our capital surplus or, if no surplus isavailable, out of our net profits for the fiscal year the dividend is declaredand/or the preceding fiscal year. We have not had net profits for the last twofiscal years ended as of December 31, 2005. However, we did have sufficientcapital surplus, defined as the amount by which our net assets exceed ourstated capital, based on par value of our outstanding shares as provided byDelaware law. Although we are currently able to pay accrued dividends on ouroutstanding shares of preferred stock, we cannot assure you that our net assetswill continue to exceed our stated capital or that we will have net profits inorder to pay these dividends in the future. These dividends continue to accrueon our outstanding shares of preferred stock, regardless of whether we arelegally able to pay them. The accrual of these dividends may adversely affectour operating results. Moreover, the payment of these dividends could strainour available cash resources, which could adversely affect our ability tooperate or grow our business.

 

In addition, ourinability to pay dividends could require us to redeem outstanding shares ofSeries 2 5% preferred stock and Series 3 5% preferred stock for shares of ourcommon stock issued at a price equal to 75% of the average of the volumeweighted average price of our common stock for the ten days ending on the dayimmediately preceding an election to redeem, subject, in the case of the Series3 5% preferred stock, to a floor of $0.87. As a result, the issuance, orpotential issuance, of these additional shares of common stock could cause ourstock price to decline. Furthermore, our inability to pay dividends couldadversely affect our ability to raise equity financing in the future ifrequired.

 

***Our acquisition of complementary products or businesses may adverselyaffect our financial condition.***

 

We have made acquisitions inthe past, and, in the future, we may acquire or invest in additional companies,business units, product lines or technologies to accelerate the development ofproducts and sales channels complementary to our existing products and saleschannels. Negotiation of potential acquisitions and integration of acquiredproducts, technologies or businesses could divert our management’s time andresources. Future acquisitions could cause us to issue equity securities thatwould dilute your ownership of us, incur debt or contingent liabilities,amortize intangible assets or write off in-process research and development,goodwill and other acquisition-related expenses that could seriously harm our financialcondition and operating results. Further, if we are not able to properlyintegrate acquired products, technologies or businesses with our existingproducts and operations, train, retain and motivate personnel from the acquiredbusiness or combine potentially different corporate cultures, we may notreceive the intended benefits of our acquisitions, which could adversely affectour business, operating results and financial condition.

 

***Compliance with export regulations may hinder our sales to foreign customers.***

 

Certain of our data securityproducts incorporate encryption and other technology that may require clearanceand export licenses from the U.S. Department of Commerce under United Statesexport regulations. Any inability to obtain these clearances or licenses or anyforeign regulatory approvals, if required, on a timely basis could delay salesand have a material adverse effect on our operating results.

 

***Provisions of our charter documents and Delaware law may haveanti-takeover effects.***

 

Certain provisions of ourcertificate of incorporation and bylaws, such as our ability to offer “blankcheck” preferred stock and the inability of our common stockholders to act bywritten consent, could make it more difficult for a third party to acquire us,even if doing so would be beneficial to our stockholders. We are also subjectto the provisions of Section 203 of the Delaware General Corporation Law,which restricts certain business combinations with interested stockholders andcould inhibit a non-negotiated merger or other business combination.

 

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***Our management and preferred stockholders exercise significant controlover our company and may approve or take actions that may be adverse to yourinterests.***

 

As of May 1, 2006, ourexecutive officers, directors and preferred stockholders beneficially ownapproximately 23.5% of our voting power. As a result, these stockholders willbe able to exercise significant control over all matters requiring stockholderapproval, including the election of directors and the approval of significantcorporate transactions, which could delay or prevent someone from acquiring ormerging with us or providing us with additional financing if required. Thesestockholders may use their influence to approve or take actions that may beadverse to your interests.

 

Item 3.           CONTROLS AND PROCEDURES

 

We have carried out anevaluation, under the supervision and the participation of our management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of our disclosure controls and procedures as of March 31, 2006,pursuant to Rule 13a-15(b) under the Exchange Act. Based upon that evaluation,our Chief Executive Officer and Chief Financial Officer concluded that ourdisclosure controls and procedures are effective in ensuring that informationrequired to be disclosed is recorded, processed, summarized and reported in atimely manner.

 

We have carried out anevaluation, under the supervision and participation of our management,including our Chief Executive Officer and Chief Financial Officer, of anychanges in our internal controls over financial reporting that occurred duringthe quarterly period ended March 31, 2006, and our Chief Executive Officer andChief Financial Officer have concluded that there was no change during thequarterly period ended March 31, 2006 that has materially affected or isreasonably expected to materially affect our internal control over financialreporting.

 

**PART II – OTHER INFORMATION**

 

Item 1.           LEGAL PROCEEDINGS

 

We are subject to legalproceedings and claims that arise in the ordinary course of business. We do notbelieve that the outcome of those matters will have a material adverse affecton our consolidated financial position, operating results or cash flows. However,there can be no assurance such legal proceedings will not have a materialimpact.

 

Item 6.           EXHIBITS

 

Thefollowing Exhibits are filed with this report form 10-QSB:

 
| 10.1 (1) |   | Loan and Security  Agreement dated as of March 27, 2006, by and between the Registrant and  Silicon Valley Bank                                                                                        |
|----------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.2 (1) |   | Intellectual Property  Security Agreement dated as of March 27, 2006, by and between the Registrant  and Silicon Valley                                                                                |
|     |   | Bank                                                                                                                                                                                                   |
| 31.1     |   | Certification of Chief  Executive Officer Pursuant to Rule 13a-14(a) of the Exchange Act.                                                                                                              |
| 31.2     |   | Certification of Chief  Financial Officer Pursuant to Rule 13a-14(a) of the Exchange Act.                                                                                                              |
| 32.1     |   | Certification of Chief  Executive Officer Pursuant to Rule 13a-14(b) of the Exchange Act and 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
| 32.2     |   | Certification of Chief  Financial Officer Pursuant to Rule 13a-14(b) of the Exchange Act and 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

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(1)   Filed as an exhibit to our Current Report onForm 8-K dated March 27, 2006, which Exhibit is incorporated herein byreference.

 

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**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the Registrant has duly caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 

 
| ** **         | **INTRUSION INC.**                                                   |
|--------------------|----------------------------------------------------------------------|
|               |                                                                 |
| Date: May 12, 2006 | /s/  G. Ward Paxton                                                  |   |
|               | G.  Ward Paxton                                                      |
|               | Chairman,  President & Chief Executive Officer                   |
|               | (Principal  Executive Officer)                                       |
|               |                                                                 |
|               |                                                                 |
| Date: May 12, 2006 | /s/  Michael L. Paxton                                               |   |
|               | Michael  L. Paxton                                                   |
|               | Vice  President, Chief Financial Officer,  Treasurer & Secretary |
|               | (Principal  Financial & Accounting Officer)                      |
|                    |                                                                      |  |  |

 

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